Roth - Traditional 401k mix (not VS.)

[bobebob]

I'm looking for some feedback on what the proper mix of Roth to Traditional balances would be good for my 401k.

My gross income is about 80K (53.6K taxable this year after pre-tax contributions and tax deductions) and I'm pretty sure my needs in retirement will put me in a lower tax bracket.  So from a purely financial perspective, it would probably make more sense for me to continue to predominately fund the traditional over the Roth.

However I have two reasons for wanting to add some significant contributions to my Roth 401k:

1. In 2016, my Roth account will be 5 years old.  And then I will be able to use my contributions as my emergency fund.  This will allow me to free up other investments I currently count as my emergency fund to do some upgrades on my house.

2. Although I expect to (on average) be in a lower tax bracket in retirement, there will undoubtedly be some situations which will require a large expenditure in a given year: buying a car, for instance.  When these events happen, taking the entire amount out of a pre-tax account in addition to my normally budgeted expenses could bump me up into a higher tax bracket and end up costing me more in the long run.

    Having an adequate balance in my Roth would allow me to withdraw post-tax money as needed to keep the tax burden down when these larger expenses come up.

So my question is what the recommended split should be between Roth and Traditional 401k contributions (balance percentages ultimately) be to give me the flexibility to manage my taxes in retirement while minimizing them overall?

I am 43 years old.

I have about $290K in my 401k.

     - only 9K of that is post-tax (Roth), and about 7.5K of that is contributions.

I want to have at least 25K in Roth contributions to count this as my emergency fund.

I have recently changed over my contribution percentages from 2% Roth & 16%Trad to 14% Roth & 0% Trad. (lowered the overall % to keep my take-home about the same)

Once I have the emergency fund amount of Roth contributions I desire, I will re-balance future contributions to give me the right mix.

So what is the right mix?

[Jazzzy]

I am 20 years older than you, so our situations are very different, but I put everything I can into Roth because I don't want to face mandatory distributions some day. (Hopefully that law won't change...but it has been proposed.) I also don't see my tax bracket going down before I would have to start taking mandatory distributions. Also, if I understand it correctly, I will never have to pay taxes on my market gains in a Roth, whereas in a traditional, you will have to eventually pay taxes on the gains. I see it as easier for me to bite the bullet now and pay on the contributions, but never have to pay on the gians....rather than delaying taxes on BOTH contributions and gains. (Please let me know if I am not understanding that correcty.)

I am looking at my Roth as an inheritance vehicle, so I hope to minimize any distributions I may have to take eventually.

My Roth is my emergency fund. I can withdraw at will at my age, but have never had to.

I would assume the answer to your question would depend on your individual tax situation, including your planned retirement date. I am 64 and am at my highest earning ever, and I love what I do and plan to continue. So, technically, even though I could retire, I am in my highest tax bracket ever.

If we only had that crystal ball..... 

[Revelate]

Roth 401k?  To keep it short, if I had one of those I'd be all over it .

I think your tax hedge ideas have merit, and the traditional 401k asset base you have will likely be sufficient otherwise assuming standard market returns over the next 3 decades anyway (I don't think people of our generation are retiring before 70).  I ran the numbers on my own taxable account and liked the results, I'm guessing from your description you're much further ahead on the traditional asset curve than I am and likely have steadier employment.

Anyway, a Roth 401k removes all the issues I have with a Roth IRA (contribution limits allow me to play catchup, and I actually could contribute with my barely above the AGI limit when really employed).  I'd be stuffing any money I could in it personally, but admittedly I'm starting to dabble in shorter-term investments and a Roth account really shines there so might not be quite as attractive for others from an investment perspective beyond the typical reasons.

[compassion101]

Re: your #1 reason above. You don't need to wait the 5 years to use your contributions from the roth. Only the earnings are subject to that 5 year period. They really should make a sticky of that because it seems a point of confusion for many people and I think alot of people could benefit from that knowledge.

[bobebob]

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@compassion101 wrote:

Re: your #1 reason above. You don't need to wait the 5 years to use your contributions from the roth. Only the earnings are subject to that 5 year period. They really should make a sticky of that because it seems a point of confusion for many people and I think alot of people could benefit from that knowledge.

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Actually, I have done some additional research and it seems that we both have some mis-understandings about Roth. Specifically that you have to be clear whether you are talking about 401k or IRA.

I was writing about Roth 401k.  What you wrote applies to the Roth IRA where a non-qualified distribution takes out only contributions until they are exhausted and then any earnings are taxed and penalized.

I have found that there is a significant difference I was not aware of with the Roth 401k:

From the IRS website itself:

http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-on-Designated-Roth-Accounts

"If you take a distribution from your designated Roth account before the end of the 5-taxable-year period, it is a nonqualified distribution. You must include the earnings portion of the nonqualified distribution in gross income. However, the basis (or contributions) portion of the nonqualified distribution is not included in gross income. The basis portion of the distribution is determined by multiplying the amount of the nonqualified distribution by the ratio of designated Roth contributions to the total designated Roth account balance."

Since taking non-qualified distributions from my Roth 401k will require me to take out the same portion of earnings as I take out in contributions, my intention of using the contributions in my Roth 401k as my emergency fund will not work as I believed it would.

It wouldn't be a huge drawback in the first few years of the account (since the balance will be predominately contributions).  But once the account accumulates significant earnings, then the penalties and taxes would become prohibitive if I needed to tap into the fund for an emergency.

Luckily, I also have a Roth IRA that I opened in 2007.  So I already have some funds that I can designate as emergency funds ($4K).

I will simply start funding the Roth IRA fully.   And after that, what I have left of my available investment money will go into the 401K.  With the smaller limits on IRA contributions, it will take me 1 to 2 additional years to build up my contributions to the point I can consider this my sole emergency fund.  No big deal. But glad I found this out now instead of when I needed it for an emergency!

It would be nice if the tax implications of both the 401k and IRA Roth accounts were equivalent (especially since they are both called "Roth").  But what am I thinking?  This IS the IRS we are talking about.

[compassion101]

I forgot that yours is a 401k not IRA. You are correct.

The ordering rules for roth IRA are that the first money that comes out is contributions you made, then conversions, then earnings. With the roth 401k it is prorated so that contributions and earnings come out simultaneously. However, that won't change at the end of 5 years unless you are over 59 1/2, dead, or disabled. You would still have a taxable amount of your withdrawings. That's definitely bad news for your plans.

Still, if you had to take out 5k tomorrow from your roth ira as an emergency, only about $830 would be taxable, at 25+10% so you'd pay around $300 total so about 6% of the withdrawal. Obviously you don't want to pay that but if you multiply that by the chance that you'll need to dip that far into emergency money then it's not alot.

I think you already mentioned having emergency money but wanting to use some of it for household repairs. Just guessing but lets say you decide you need/have 25k of emergency funds. If you dip into it 10k worth it will still leave you with 15k of emergency funds plus 9k in your roth which can be counted as emergency funds with a 6% penalty. Chances are probably pretty low that you'd ever have to tap into those funds.

[bobebob]

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@compassion101 wrote:

I forgot that yours is a 401k not IRA. You are correct.

The ordering rules for roth IRA are that the first money that comes out is contributions you made, then conversions, then earnings. With the roth 401k it is prorated so that contributions and earnings come out simultaneously. However, that won't change at the end of 5 years unless you are over 59 1/2, dead, or disabled. You would still have a taxable amount of your withdrawings. That's definitely bad news for your plans.

Still, if you had to take out 5k tomorrow from your roth ira as an emergency, only about $830 would be taxable, at 25+10% so you'd pay around $300 total so about 6% of the withdrawal. Obviously you don't want to pay that but if you multiply that by the chance that you'll need to dip that far into emergency money then it's not alot.

I think you already mentioned having emergency money but wanting to use some of it for household repairs. Just guessing but lets say you decide you need/have 25k of emergency funds. If you dip into it 10k worth it will still leave you with 15k of emergency funds plus 9k in your roth which can be counted as emergency funds with a 6% penalty. Chances are probably pretty low that you'd ever have to tap into those funds.

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I have about 22K worth of gold and silver I count as my emergency fund.  I have good lines of credit, so the slight illiquidity wouldn't affect it's use for that.  I'd be able sell it off in a week or so to pay of the credit cards I'd use in an emergency.

The plans for my house are more along the lines of re-modeling vs repairs.  So it's not something I'm in dire need of doing right away.  Just want to have another source for emergency expenses in place before I sell off the coins.

I'm pretty good about what is a true emergency expense (i.e. Home air conditioner breaking down vs Christmas presents).  So it is less likely to be used.  But I would still hate to have the penalties.